I remember following Martin Zweig years (decades) ago and in fact used one of the techniques he

described in his book, “Winning on Wall Street,” in the mid-1980s' (1984 to be exact). In it he described a
really simple technique using his unweighted index (ZUPI); trading it on a weekly basis whenever it moved
four percent or more. If it moved up four percent in a week, he bought, if it moved down four percent in
one week, he sold. Positions were held until the next opposing signal – just that simple. The problem I had
back then was not only in not following it as he described, but in trying to tweak it into something
better. Eventually experience told me that he had already been down that road and I was the beneficiary of
the results. Anyway, I took this concept and used it on Index/ETF pairs, actually calculating the ratio of
Index/ETF pairs and using the weekly movement of four percent to swap between the numerator and the
denominator. It really works well with asset classes that are not correlated, such as equity versus fixed
income or equity versus gold, etc. Chart A shows an example of this pair strategy using ETFs for the S&P
600 small cap index (IJR) versus the BarCap 7-10 Year Treasury index (IEF). The ratio line is the typical
price line in the upper plot while the lower plot is the percent up and down moves for each weekly data
point. Remember, this is a weekly chart. Whenever the ratio line moves up or down by 4% in a week as
shown by the lower plot moving above or below the horizontal lines shown as +4% and -4%. Repeated
moves in the same direction are ignored.

You can see that it appears to trade quite a bit; but remember it is weekly not daily. And 10 round turn
trades in almost 5 years really isn’t much. Think of the ratio line like this: when it is moving upward it
means the numerator (IJR) is outperforming the denominator (IEF). So, here is how it works! I had to start
that way because it is confusing. When the Rate of Change (ROC) goes below the -4% line, it means the
numerator (IJR) is no longer outperforming the denominator (IEF). Hence, you want to rotate into the
denominator (IEF); or sell IJR and buy IEF. When the ROC goes above the +4% line it means the
numerator is now outperforming the denominator, so you want to sell IEF and buy IJR. Also, the signals
are at the crossing of the + and – 4% lines, not at the peaks and troughs of the ROC. Confused? Try
explaining it; I went through 3-4 iterations. One last effort: Think of a buy signal (green arrows in Chart A)
as buying the denominator (IEF) and selling the numerator (IJR). This is completely different than typical
technical analysis indicators since you are trading a ratio instead of individual security.

Red Arrows - buy IJR and sell IEF

Green Arrows - buy IEF and sell IJR

TEST QUESTION (rhetorical): Why wasn’t there a buy signal near the first of October 2014?
 Chart A

Using SharpCharts, you can do this ratio with a colon (:) between the symbols and the indicator "Rate of
Change" with parameter set at 4.

The ratio significantly outperformed each of the individual components (IJR and IEF) and the S&P
500. Chart B shows the performance of the ratio with the numerator and denominator swapped whenever
there was a move of 4% or greater, the performance of the individual components that make up the ratio,
and the S&P 500.
 Chart B

Table A shows the annualized performance statistics from 01/02/1998 until 12/28/2012 (weekly data). The
Sharpe Ratio is slightly modified in that the return is used as the numerator without a reduction for risk free
return. The Ratio rotation strategy outperformed in annualized return, and when compared to the equity
component it reduced the Drawdown (DD) considerably, improved the Sharpe Ratio, and lowered the
Ulcer Index.

Table A

I also found that smoothing the ratio with just a 2-period simple moving average greatly enhanced the
performance because it reduced the number of trades. Chart A at the top of this article was without the 2-
period smoothing; it might have reduced the number of trades. Trying different percentages other than
Zweig’s four percent worked well occasionally, but overall, the four percent on weekly data yielded the
most robust results time and time again. The real advantage for a pair rotation strategy is when it is used as
a core holding situation. In other words, if a strategy required a core holding percentage but that core could
be actively managed, this would give an actively managed core holding that would have much lower
drawdowns that a buy and hold core, and considerably better returns. I’ll expand on this concept with a
Core Rotation Strategy in the next article.

TEST QUESTION Answer: Repeat signals in the same direction are ignored.
My long-time friend and superb trader, Linda Bradford Raschke has finally written a book about her life in
trading. Folks, this is a great read that will offer so many tidbits of knowledge on trading you won’t be
able to put it down. I was honored to read the draft and make comments. It won’t be on Amazon from a
year, but you can order it HERE.

Dance with the Trend,

Greg Morris

Pair Analysis 02

To prove that I read all comments, here are some pair charts and data that is updated to 12/31/2018. First a
review of what pair analysis is.

My pair analysis is accomplished on weekly data. Think of the ratio line like this: when it is moving
upward it means the numerator (IJR) is outperforming the denominator (IEF). When the Rate of Change
(ROC) goes below the -4% line, it means the numerator (IJR) is no longer outperforming the denominator
(IEF). Hence, you want to rotate into the denominator (IEF); or sell IJR and buy IEF. Complementarily,
when the ROC goes above the +4% line it means the numerator is now outperforming the denominator, so
you want to sell IEF and buy IJR. Also, the signals are at the crossing of the + and – 4% lines, not at the
peaks and troughs of the ROC.

Chart A is the IJR:IEF ratio pair. I'm showing this pair since it is the one I introduced in the first article on
Pair Analysis. The Core for this chart is the S&P 500 Index. The gray background shading is the time
when IJR is the investment since it is the numerator. Obviously (I hope), the white spaces are when the
denominator is the investment, and in this case, it is IEF. This data and chart also smooths the ratio line
with a 2-period simple moving average. While that process does not affect the performance that much, if
any, it does reduce the number of trades. When dealing with a 1-period rate of change (ROC), you will
have many sharp peaks and troughs outside of the 4% range; the 2-period smoothing eliminates many of
them without great sacrifice in performance. Also keep in mind that this is NOT a robust analysis; it was
an idea I had years ago and wanted to share with you. In fact, it was in early 2013, which is why the first
article’s data ended about then.
Chart A

Chart B shows the excess return of the IJR:IEF pair strategy to the S&P 500 Index. I must point out that
this does not include commissions, slippage, and all the other potential issues that deal with live trading. It
is just the raw results using the closing price on Friday (remember, this strategy is using weekly
data). Viewing the excess return, you can see many flat areas where there wasn’t any improvement in
return over the S&P 500. Of course, only in hindsight can you see that. Reference to "excess" means
above the risk free return, which in most analysis is the 90-day T-bill rate.

Chart B

Chart C is the cumulative drawdown for the S&P 500 Index (black) and the IJR:IEF Pair Strategy (cyan).
The dotted lines are the average of those drawdowns. Low drawdown is of great value when you are
actually trading with real money.
Chart C

Chart D is the 1 year rolling correlation of the IJR:IEF pair strategy with the S&P 500 Index. You can see
it is not well correlated; with the average (orange line) being slightly negatively correlated. The bottom
plot in Chart D shows the distribution of the 1 year rolling correlation. You can see from the distribution
that more of the correlations were in the negative side. Basically, it says that the IJR:IEF pair strategy is
not correlated with the S&P 500 Index.

Chart D

Table A shows a bunch of statistics and performance data on the IJR:IEF pair strategy. UPI is the Ulcer
Performance Index, which compares the issue with the core performance (UPI = (Total return - Risk-free
return) / UI). Core refers to the S&P 500 Index. 1.24 trades a year is delightful. In Pair Analysis – 3, I’ll
show you the information when the 2-period SMA is not used.
 Table A

In Pair Analysis - 3, I’ll show Chart A for a few other pairs. Many work well, but some do not. Obviously,
in showing you an example, I picked a pair that did. My analysis included over 700 pair combinations.

My long-time friend and superb trader, Linda Bradford Raschke has finally written a book about her life in
trading. Folks, this is a great read that will offer so many tidbits of knowledge on trading you won’t be
able to put it down. I was honored to read the draft and make comments. It won’t be on Amazon from a
year, but you can order it HERE.

Dance with the Trend,

Greg Morris